Market monetarism: a first look

One of the more confusing of the macroeconomic debate is the emergence of a profusion of schools of thought with very similar names, but very different viewpoints. The one I’ve had most to deal with is Modern Monetary Theory. I had a go at this topic here and . My brief summary is that MMT pretty much coincides with traditional Keynesian views in the context of a liquidity trap, but that I reject the claim commonly made in popular presentations of MMT, that increased government spending doesn’t imply increased taxation.

Then there’s New Monetarism, associated with Stephen Williamson. He and I had a set-to a while back, which entertained many but didn’t produce a lot of enlightenment, and left me disinclined to put a lot of effort into understanding the differences between New and Old Monetarism. (For the record, I’m pretty much an Old Keynesian, but I have learnt a fair bit from New Keynesians like Akerlof and Shiller).

The third entrant is “Market Monetarism” associated mainly with Scott Sumner (though Wikipedia tells me the term was coined by Lars Christensen). I was aware in general terms that Sumner advocated a more expansionary monetary policy in response to the current crisis (I agree), that he prefers Nominal GDP level targeting to inflation targeting as the basis for monetary policy (I agree again though I’d prefer targeting levels rather than growth rates) and that he thinks this would be sufficient to fix the problem without any role for fiscal policy (I disagree). However, I wasn’t really aware that these ideas formed the basis of a school of thought, and I still haven’t investigated the underlying theory in any detail.

Sumner has commented on my recent posts on fiscal and monetary policy with a couple of his own, so I guess it’s time for me to look more closely at what he is saying. A first response is over the fold.

There is a lot in these posts that makes no sense at all to me – I usually find that in cases of this kind there is fault on both sides. Responding to all Sumner’s claims seems likely to produce the worst kind of blogospheric mess, so I’ll focus on what I take to the key point.

In his first post, Sumner is mainly concerned to use me as an example of his claim that the economics profession wrongly equates low interest rates with easy money.

He starts with a bit of a gotcha, in that the original version of my post looked at a huge reduction in nominal rates of interest (from 17.5 per cent to 5.25 per cent) without adjusting for the small change in inflation expectations that took place at the same time (from about 7 per cent to 4 per cent). As I said in the update, the example works just as well if you look at the reduction in the real rate from 9 per cent to 1 per cent. But this is a side issue, since Sumner says “real interest rates are not much better.

At this point, it's difficult to see why Sumner is bothering to pick bones with me. The idea that the stance of monetary policy can be assessed as expansionary, neutral or contractionary depending on whether the interest rate controlled by the central bank is at, above, or below its real long run average neutral value isn't just mine. It's that of nearly all economists, notably including the US Fed. UpdateThe neutral value changes gradually over time in response to a variety of factors, but is sufficiently stable that it can be regarded, for most purposes, as a long-term average, typically assumed to be in the range 1.5 per cent to 3.5 percent. End updateSumner claims that “People get defensive when I make fun of the view that low interest rates mean easy money” but doesn’t name any names. Does anyone really deny that this is the standard view?

So far, despite a lot of heat, there is no real disagreement. Sumner says, and I agree that, under normal conditions, most economists assess the stance of monetary policy by looking at the real interest rate controlled by the central bank. This wasn’t always the case. The term “monetarism” is generally associated with Milton Friedman’s view that the central bank can and should target the rate of growth of (some measure of) the money supply. This definition has a lot of problems, though it has the merit that it’s applicable even when nominal interest rates have reached the lower bound of zero. But that doesn’t matter much because Sumner doesn’t like Friedman’s approach any more than I do.

Sumner’s alternative, as I understand it comes down to three propositions
(1) The central bank can set policy to achieve whatever rate of nominal GDP growth it desires
(2) Nominal GDP growth can be regarded as a policy instrument, in the same way as the cash rate or, in Friedman’s version of monetarism, the money supply
(3) The best measure of the stance of monetary policy is the expected rate of nominal GDP growth

If you grant the first of these propositions, the others follow pretty directly. But most economists, including central banks, don’t think it’s true, at least in the context of a liquidity trap. It’s hard to assess the argument without a clear and quantified statement of what monetary policies would be needed to end the current recession. Perhaps Sumner has set this out somewhere, and if so, can link to it. It’s worth pointing out that the Keynesian advocates of fiscal stimulus, notably including Romer and Krugman, have been willing to specify the size of stimulus they think was needed in 2009 and would be needed now.

If you don’t accept (1), then the whole argument becomes circular. An expansionary monetary policy, on Sumner’s view, is one that expands the economy. In that case, of course, expansionary policy could never fail, in much the same way as treason never prospers.

Going a bit more out on a limb, I don’t think the validity of the liquidity trap argument depends on whether interest rates have reached the zero lower bound. The economy is in a liquidity trap when people want to build up money balances, regardless of the consumption and investment opportunities available to them. If central banks face such a situation, they may give up on interest rate reductions, even before the rate hits zero, if only to avoid making their impotence obvious.

Anyway, that’s enough from me. I expect there will be plenty of responses and I hope they may help to illuminate the issues.

91 thoughts on “Market monetarism: a first look

  1. An inflation target is easier to understand, easier to police and easier to include in economic calculations. Hayek supported a nominal income target too.

  2. All market monetarist bloggers that I can think of support level targeting, and believe that the stance of monetary policy should be assessed as NGDP growth relative to trend

  3. I’m not a pro at this stuff but I have been reading Sumner for a fair while. I think, as Quiggin does, the key point is the question of “Can a central bank achieve a given level of NGDP if it so desires?” Since the components of NGDP are RGDP and inflation, we might as well rephrase that question as “Can the central bank achieve a given level of inflation if it so desires?”

    Krugman and many others appear to say no, not if the economy is in a liquidity trap. I offer a thought experiment – suppose the central bank were to put $1 trillion in the bank account of every man, woman and child. Would prices really not increase? I find it hard to imagine that they wouldn’t. So the central bank must have the ability to control inflation – which in turn means it has the ability to control NGDP.

    Quiggin defines a liquidity trap as being when people want to build up money balances. If so, great – create the money for them to build up those balances with. That desire has to get satiated at some point and they will start spending again.

  4. An inflation target could work just as well as an NGDP level target, if it were the correct target. Bernanke appears to be targeting “not-deflation” at the moment all of his excuses and rhetoric to the contrary. An NGDP level target – the economy running at capacity without runaway inflation – at the correct level would highlight Bernanke’s shortfall and failure more than an inflation target.

    As Krugman wrote, the monetarists are opposed to government spending for some reason. Sumner assumes monetary policy can compensate for fiscal policy. It probably can, but why should we want it to? Why not have them work in concert? If the next Fed Chair pulled a reverse Volcker, there would probably be a backlash from the lunatic rightwing even if the economy improved.

  5. @Nathan When discussing what, say, the US Federal Reserve Board can and can not do, at least a passing hint of a shred of a reference to the Federal Reserve Act would be nice. The Fed is no more allowed to implement the policy you consider than you are. It may buy and sell Federal Government issued securities, loan to depository institutions, loan to other firms if and only if there is an ongoing financial crisis and set reserve requirements (plus regulate in other ways).

    The policy you describe is called “fiscal policy.” You have not begun to consider the limits on the effectiveness of monetary policy in a liquidity trap, because you have completely ignored binding law. This is not a good approach to figuring out what people do and do not have the authority to do.

  6. “I was aware in general terms that Sumner advocated a more expansionary monetary policy in response to the current crisis (I agree), that he prefers Nominal GDP targeting to inflation targeting as the basis for monetary policy (I agree, though I’d prefer targeting levels rather than growth rates) and that he thinks this would be sufficient to fix the problem without any role for fiscal policy (I disagree).”

    Scott Sumner advocates Nominal GDP *Level* Targeting, as do all Market Monetarists. In fact Nominal GDP *Level* Targeting is such a central concept to MM that it has acquired the acronym NGDPLT.

  7. @Peter K.

    “As Krugman wrote, the monetarists are opposed to government spending for some reason.”

    This is a grossly simplistic characterization of Market Monetarist views.

    Market Monetarists believe that monetary policy is never impotent, hence fiscal policy may always be offset. However some MMs are open to fiscal stimulus. David Beckworth has written favorably about “helicopter drops” (see for example his post entitled “A Foolproof Approach to Monetary Policy For Both Fiscalists and Monetarists” at Macro and Other Market Musings on June 13, 2013). Nick Rowe has said that he is a “belt-and-suspenders kind of guy,” and hence he is not at all opposed to fiscal stimulus.

    On the other extreme is Scott Sumner who sees fiscal stimulus as a complete failure to hold monetary policymakers accountable.

    My personal take (I do not label myself Market Monetarist) is that as long as we have a large output gap it makes little sense to be opposed to fiscal stimulus. However, if you truly believe that monetary policy is never impotent (I share this belief), then fiscal stimulus cannot overcome bad monetary policy. What it may do however is more fully expose the fact that it is poor monetary policy which is reponsible for the large output gap.

  8. @Robert Waldmann

    “It may buy and sell Federal Government issued securities, loan to depository institutions, loan to other firms if and only if there is an ongoing financial crisis and set reserve requirements (plus regulate in other ways).”

    This is mostly true but in the interests of clarity let me add the following.

    Section 14 of the Federal Reserve Act (FRA) sets out the rules governing Fed asset purchases. According to Section 14.1 the Fed may purchase gold, Treasury debt, Agency debt and Agency guaranteed debt. The open market stipulation prevents the Fed from purchasing Treasury or Agency debt directly (that would be “monetizing the debt”) so it must buy Federal government debt (interestingly, this does not apply to any other asset the Fed may puchase) in the secondary markets. This of course has not proved to be much of an impediment.

    The Fed is also permitted to purchase bankers acceptances and bills of exchange in the open market. These are privately issued assets but few American institutions use much of them anymore.

    The Fed is also allowed to purchase state and municipal debt
    and foreign government issued and guaranteed assets, as well as those of their agencies with a term not exceeding six months. The term constraint is important since about 99% of state and municipal bonds, and something like 88% of foreign bonds are of longer term.

    So what’s eligible for purchase? Roughly…

    Federal government Treasuries – $11.5 trillion
    Agency bonds – $2.1 trillion
    Agency guaranteed securities – $5.8 trillion
    Bankers acceptances – zilch
    Gold – $7.8 trillion
    State and municipal bonds – zilch
    Foreign bonds – $5 trillion

    This comes to about $32.2 trillion dollars. Now, the Federal Reserve currently holds about $3.4 trillion in such assets so that leaves about $28.8 trillion in assets that they still haven’t bought.

    (And I suppose they can buy up all the world’s foreign currency and overnight deposits which ought to be worth at least a few trillion dollars but let’s not get crazy!)

    And I still haven’t touched on section 13.3 of the FRA yet.

    Section 13.3 allows the Fed to lend to any *individual*, partnership, or corporation upon any collateral the Fed deems satisfactory. That’s the Section that allowed the Fed to create Maiden Lane I, II, and III, the Commercial Paper Funding Facility (CPFF), and the Term Auction Lending Facility (TALF) during the financial crisis. Approximately $2 billion is still currently lent out under Section 13.3 (through Maiden Lane and TALF).

    In theory under Section 13.3 private label MBS, CDOs, stocks or corporate bonds are all eligible collateral so the sky is the limit. In practice section 13.3 only allows loans under “unusual and exigent circumstances.” But guess who gets to decide what consitutes “unusual and exigent circumstances?”

    So yes, the Fed is legally prohibited from depositing money into the bank accounts of individuals with no strings attached, or, indeed, from buying up the global supply of cheese. But this accounting suggests there’s still ample room to “print” more money if the Fed so chooses.

  9. With regards to “low real interest rates is stimulative”, it seems there is no doubt that is the standard view currently. Before the 1980s, howver, there was concern that high interest rates were inflationary; in other words the interest income channel dominated time preference effects. I do not know the literature enough to know what school of thought this was associated with.
    After the Volcker experiment, that debate seems largely dead.

    This is based on what I read of market economists and strategists that was in the archives I used to have access to; I do not know whether this view was reflected in the academic literature of the time.

    The MMT theorists (Warren Mosler in particular) have revived this school of thought. In the current context, the fear is that low rates are strangling consumption growth. There are a few other market strategists who have noted this concern, but it seems it is very much a minority view.

  10. @Robert Waldmann

    “The open market stipulation prevents the Fed from purchasing Treasury or Agency debt directly (that would be “monetizing the debt”) so it must buy Federal government debt (interestingly, this does not apply to any other asset the Fed may puchase) in the secondary markets.”

    should read

    “The open market stipulation prevents the Fed from purchasing Treasury or Agency debt directly (that would be “monetizing the debt”) so it must buy Federal government debt in the secondary markets. (Interestingly, this does not apply to any other asset the Fed may puchase except bankers acceptances and bills of exchange.)

  11. “I reject the claim commonly made in popular presentations of MMT, that increased government spending doesn’t imply increased taxation.” – Prof JQ.

    If you literally do that you are making at least two mistakes. One, you are critiquing popular views of MMT, not considered academic and professional views. Two, you are over-simplifying (into a straw-man argument) the MMT position. The MMT position is that increased government spending might imply, depending on circumstances and particular decisions, any one item or some items of;

    (a) increased taxation;
    (b) decreased surplus;
    (c) increased deficit;
    (d) increased borrowings.

    MMT requires a certain nuanced understanding of what it is saying. As you are clearly intelligent enough to understand nuances, one wonders why you persist in simplistic misrepresentation. The reason has to be an ideological blindspot and/or an aspect of your economic training and now intellectual position which is based on dogmatics rather than empiricism.

    How you can claim to be a left liberal and then support modern Labor (a very right wing party) is beyond me. Doublethink I guess.

  12. @Ikonoclast

    You should be talking to the MMT fans who present these simplistic and wrong versions of the theory, or to the more sophisticated theorists who don’t (IMHO) do enough to correct the errors of their followers. Or you could respond yourself. I have to respond to what is presented in public debate, which is mostly the silly stuff.

  13. How you can claim to be a left liberal and then support modern Labor (a very right wing party) is beyond me. Doublethink I guess.

    As regards the government, we only get a choice of two, and Labor is certainly better than the Libs. You’ve been reading long enough to know they are not my first preference.

  14. “The idea that the stance of monetary policy can be assessed as expansionary, neutral or contractionary depending on whether the interest rate controlled by the central bank is at, above, or below its real long run average value isn’t just mine. It’s that of nearly all economists, notably including the US Fed.”

    John Quiggin then links to the Federal Reserve where it clearly says:

    “In addition, most economists agree that the neutral rate is not constant over time. Just as economic conditions are constantly changing, so does the monetary policy direction at a given time that would be consistent with neutrality. The factors that determine the neutral range are complicated and varying; as Dr. Yellen further noted in the same interview:

    [“The neutral real rate itself depends on a variety of factors – the stance of fiscal policy, the trend of the global economy which shows up in our net exports, the level of housing prices, the equity markets, the slope of the yield curve, or the term premium built into the yield curve. So it changes over time.”]”

    This is something to which I discussed at length in John Quiggin’s post entitled “A note on the ineffectiveness of monetary stimulus”. Simply lowering the policy rate below the long run neutral interest rate does not make monetary policy expansionary. Typically in a recession the short run real neutral rate is lower than the long run real neutral rate.

    I had a hard enough time convincing him that the real call rate target was above the long run real neutral rate in Australia during most of January 1990 through December 1992 that I just gave up on even going there.

  15. “Simply lowering the policy rate below the long run neutral interest rate does not make monetary policy expansionary.”

    should read

    “Simply lowering the real policy rate below the long run real neutral rate does not make monetary policy expansionary.”

  16. @Mark A. Sadowski

    Fair enough. I’ll edit to give a more precise statement. But allowing for a time-varying neutral rate doesn’t help your argument at all, quite the opposite. The Fed graph shows that the (estimated) neutral rate for the US was higher in the late 80s and early 90s than it is now. That was certainly true in Australia as well, at least in the perception of policymakers. As I said, their guiding assumption was that the economy would recover quickly in response to the interest rate cuts.

    I don’t think people talked in terms of neutral rates at the time – the shift from money supply targeting to inflation targeting based on interest rates was still under way, and the language hadn’t fully adjusted – but there was a definite consensus that monetary policy was expansionary until the tightening in 1994.

  17. If you want to understand Scott’s views these FAQs are a good place to start.

    There is also a ‘Quick intro to my views’ section on his sidebar.

  18. If I may try to channel Scott, I think he would justify “(1) The central bank can set policy to achieve whatever rate of nominal GDP growth it desires” mainly through the expectations effect of a level target.

    It is pretty standard (PIH/lifetime income/consumption Euler equations) to assume that current spending depends on expected future income and interest rates. (Most explicity for consumption but a very similar argument applies to investment.)

    If people believe the central bank can hit the level target eventually (which is less controversial), their future income is reasonably secure, and low inflation now means higher future inflation, thus cutting real interest rates. Both should exert a powerful stabilising effect in the face of a downturn, making it less likely to hit the ZLB in the first place, and less of a problem if it is reached. A lot of the “pushing on a string” type arguments (e.g. the Galbraith quote from a previous thread) seem to depend on uncertainty or lack of “confidence” about future income/demand.

    (This is my understanding of Scott’s views, though with more about interest rates than he might like. Personally I think NGDP has been too volatile in the recent past to be a good target for Australia.)

  19. Notwithstanding Ikonoclast’s discussion of the particulars mentioned, MMT is at least useful in moving the role of credit (debt) creation away from the private sector banks and within vertical control of the state. Liquidity trap conditions are highlighted by divergence between market interest rates and official (policy) rates and bond yield curve. And vested interests have a, well, ‘vested interest’ in preventing politics from trumping them on this front. If this can be achieved, the role of taxation (alongside MMT-type monetary operations) is in concert with post-keynesian (the specific theories of Keynes, before ‘bastard Keynesianism) policies of investment, resource distribution and distributive justice.

    That’s the link between the two in practical terms.

  20. @Mark A. Sadowski

    This comes to about $32.2 trillion dollars. Now, the Federal Reserve currently holds about $3.4 trillion in such assets so that leaves about $28.8 trillion in assets that they still haven’t bought

    What is the purpose of such spending? To save banks.
    Why QEx do not produce inflation? Cause it helps banks to survive, only.
    If healthy banks (who are not healthy yet) have someone to lend to then it would be ok and monetary policy would work.

    It seems that you MM guys still working out the problem from 2007-2008 when bank lending was reduced by attacking lending fraud prevelent from previous years.

    That problem of insolvency of banks was solved long time ago just by introducing pricing assets to model instead of pricing paper assets to market.

    FED is keeping banks NOMINALY solvent. Why are you guys wasting time with solved problem when REAL problems are still present?

  21. QE liquidity has effectively gone directly to private banks’ bottom lines to patch up the extreme greed-fuelled blunders leading up to 2008, with a sizeable portion then gambled on speculative plays in equity markets. We are really now seeing the absolute failure of monetarism and ‘supply-side economics’ (bedfellows of the dubious, but ubiquitous, political ideology of neoliberalism) writ large.

    ‘Cheap money’ helped get us here. From the ideological malevolence beginning with Ronald Reagan in the 1980s (the “trickle down hypothesis”), US Federal Reserve Chairman Alan Greenspan well and truly distorted the global economy by making the cost of money too cheap for too long, hiding financial risk behind artificially closing spreads, and thus creating successive asset bubbles more inherently risky than markets cared to believe. Ben Bernanke then took over only to compound the whole mess.

  22. J.Q.

    I reject the claim commonly made in popular presentations of MMT, that increased government spending doesn’t imply increased taxation.

    Then where did all that government debt come from?
    Is it all from negative trade balance? Or also from somewhere else?

    Where from is all that government debt besides years of negative trade balance?

    From years of INCREASED government spending without increased taxation and service of such debt.

  23. I meant “increased government spending doesn’t imply *a requirement for* increased taxation”. Follow the link if you’re unclear

  24. J.Q.
    You can calculate, or some of your students could, how much did government spend above taxation in years till present if total debt is reduced by negative trade and debt servicing while adding international investment income by a government.
    I have no resources nor time to do such calculations.

    Hopefully you could find some new info that will make you think again about increased government spending and where it comes from.

  25. I read it for a second time and still find it incorrect since you were talking about accounting correctness and then switch the word “tax” in

    then any expansion of the money supply is effectively an inflationary tax on money balances

    with non accounting meaning.
    In it, it is correct that inflation switch spending power from “savings” to government, but not as accounting matter where taxes finance spending.

    Inflation as “tax” but also debt relief has very redistribution effect is the central to neoliberla/ libertarian thinking against it, even tough it is what kept economy prosperous for years. And it is why neoliberal dogma has moved Central Bank policies and especialy in EU against inflation only.

    It is such succes against inflation that is the the main mechanic on why this GFC developed over time. There was no debt relief through many years of low inflation, only from easing debt terms.
    Now there is the end of easing on debt terms which started GFC, and leaving majority of people with high debt and no relief.

    No REAL interest rate shows such mechanism, so why bother with it in previous posts?

  26. @Mick
    Cheap money is a result of saving glut that needed investment placing.
    There was no realizable investment options with lower private income in the market. To improve investment options of savings FED reduced rates. (To be fully correct, since interest rates work through credit creation not through saving reinvestment, low interest rates increase credit creation = spending on investment and consumption. Saving serves only as loan deposits which become bank reserves at the FED which is replaced with Tsy’s when too much of it to control cash rate. This is description of Fractional Reserve Banking)

    Why was there saving glut?

  27. J.Q.
    Knowledge of public debt is highly emotional and hence has politicly strong influence on population and economists which is constantly used and mostly abused. Info on public debt is highly negative for policy prescriptions and it is totaly irrelevant economicaly which example of Japan is teching.
    It is irrelevant for countries with flexible exchange rate and debt in own currency, but still it is so abused that represents focal points of some political parties.

    MMT recomendations on monetizing the public debt with High Value Soveregin Coin is for the sole purpose of neutralizing political influence that info on public debt has on population so that fiscal policy comes back as a main issue.

    I would argue that monetary policy was right prety much since 1933 given the conditions of the market (private sector). It is the fiscal policy that was at fault for producing GFC.
    Fiscal policy with its taxation and subsidy regime was at fault. Not particullary the ammounts of spending but where such spending was used.

    It is a waste of time to discus monetary policies which were correct most of the time, maybe a little late or too early.

    It is the fiscal policy that is at fault, not monetary policy which is btw following MMT (or to be more precise MMT is a description of monetary policy and mechanisms from those that were involved in it)

    You can find in Ben Bernanke speaches that he is doing all he can to provide relief to private sector and to enable wide range of governmental fiscal policy at the same time but that it is up to Congress to implement correct fiscal policy. He doesn’t say it openly since that would be “nonindependent FED” but it is there between the lines and implicitly.

  28. @John Quiggin

    “But allowing for a time-varying neutral rate doesn’t help your argument at all, quite the opposite. The Fed graph shows that the (estimated) neutral rate for the US was higher in the late 80s and early 90s than it is now.”

    The Fed graph (Figure 3) is clearly labeled “Approximate range of estimates for a neutral *nominal* funds rate”. Yes this is not very helpful given the text that immediately precedes it refers to the *real* neutral rate. This is especially true given that inflation was much higher in 1989 than it was in 2004 (the range of the graph).

    The range of estimates goes from about 5.6% to 7.2% in January 1989. The yoy PCEPI inflation rate was 4.4% in January 1989 so the range runs from 1.2% to 2.8% in real terms. In comparison the range of estimates goes from 2.8% to 4.4% in March 2004. The yoy PCEPI inflation rate was 1.8% in March 2004 so the range runs from 1.0% to 2.6% in real terms. The graph would have been much more relevant if it had been corrected for inflation.

    I’ll include a link to the inflation rates in a subequent comment.

    John Quiggin:
    “That was certainly true in Australia as well, at least in the perception of policymakers. As I said, their guiding assumption was that the economy would recover quickly in response to the interest rate cuts.”

    Ian Macfarlane, who was an Assistant Governor from 1990 to 1992, and Deputy Governor from 1992 to 1996 under Governor Bernie Fraser, said the following in one of his 2006 Boyer lectures (I’ll include a link in a ubequent comment):

    ”We did not set out to have a recession in order to reduce inflation. … But once it was apparent that it was going to happen, it was reasonably quickly realised that there was an opportunity to achieve something of lasting value out of the unfortunate events.”

    Here is what Governor Bernie Fraser said in August 1992 (I’ll include a link in a subsequent comment):

    “I trust those comments can be made without arousing suspicions of being or going
    soft on inflation. It should be obvious from the performance of monetary policy over recent years that there is no basis for such suspicions. Australia now has one of the lowest rates of inflation in the world. Inflation has come down faster than everyone expected, but it is not just the recession, or a fluke, that has caused it to decline. Policy has been important, and the costs substantial. Price expectations, which are now seen as occupying a central role in the inflationary process, have been cracked; given this, together with continued policy vigilance, there is no reason why the current underlying inflation rate of 2 to 3 per cent cannot be sustained.”

    John Quiggin:
    “I don’t think people talked in terms of neutral rates at the time – the shift from money supply targeting to inflation targeting based on interest rates was still under way, and the language hadn’t fully adjusted – but there was a definite consensus that monetary policy was expansionary until the tightening in 1994.”

    Even if was true that policymakers thought monetary policy was expansionary at the time, which I think is highly dubious in light of the above quotes, the important thing is that *we* know that the real call rate was above the long run neutral rate from January 1990 through November 1991, so monetary policy clearly was not expansionary during that time span. And were I to estimate a time varying real neutral rate using conventional econometric methods I am quite confident it would show that the real call rate was above the short run real neutral rate throughout 1993.

  29. @John Quiggin

    Here is a link to the yoy PCEPI inflation rates and the fed funds target rate in the US from January 1989 through January 2005:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135203&category_id=0

    Here is a link to Ian McFarlane’s 2006 comments:

    http://www.theage.com.au/news/business/the-real-reasons-why-it-was-the-1990s-recession-we-had-to-have/2006/12/01/1164777791623.html?page=fullpage#contentSwap1

    Here is a link to Bernie Fraser’s 1992 comments (see page 7):

    Click to access bu-0992-1.pdf

  30. @John Quiggin

    Fair enough on both replies. You have been remarkably tolerant. I am probably taking my frustration with Australia’s entire system out on you when there are clearly many much more deserving targets (outside of people on this blog I mean). If I get OTT, delete the offending comment(s) and warn me. I need to take a chill pill I think.

  31. @Mark A. Sadowski
    You’re quite right on the neutral rate graph – I was misled by the surrounding text. I think that adjusting for inflation would remove the decline at the beginning of the period. That would leave the range of estimates pretty much constant.

    As regards the views of policymakers, as I’ve already said, I’m much more inclined to place weight on Bernie Fraser’s statements at the time than on the retrospective claims made later on. In Fraser’s speech, the remarks you cite are obviously a defence against the widespread perception that policy was not merely expansionary, but too expansionary. That’s clearer in the following para

    As inflation has come down and unemployment has risen, more emphasis has come, understandably, to be placed on growth and jobs. How should the authorities respond? One response is to say that we have never had a single-minded fixation with price stability. That, clearly, has been the situation in recent years. In each of the thirteen announced reductions in cash rates since January 1990, the authorities (meaning the Government and the Bank) have acknowledged the importance of trends in both inflation and activity in those decisions.

  32. A side point on which I need to clarify my own thoughts. In assessing the stance of both fiscal and monetary policy, I tend to think that both the level and the change need to be considered. In relation to fiscal policy, for example, a shift in the primary balance from, say +3 to -2 per cent of GDP seems to me to be a bigger deal than a shift from -2 to -3.

    Similarly, I think the magnitude of the shift in monetary policy over this period is at least as significant as the end point. This depends on a story about expectations, which involves a complex game between the public and the monetary authorities. As a first approximation, and with reference to Sumner’s approach, I’d say the following. Cutting rates by 12 percentage points is a clear signal that the authorities want to raise the level of nominal GDP sufficiently to reduce unemployment and will do what they think is necessary to achieve that. The fact that this didn’t happen suggests to me that the power of the central bank to shift expectations is not that great, once a severe recession is underway.

  33. @Jordan

    “What is the purpose of such spending? To save banks.”

    The purpose of QE is to increase aggregate demand (AD). It’s true that QE also increases the amount of bank reserves but why would this benefit banks?

    “Why QEx do not produce inflation?”

    Inflation is not the correct measure of the success or failure of policies designed to increase AD because shifts in aggregate supply (AS) also influence the inflation rate.

    The following link is to a dynamic AD-AS diagram, and which can be found in “Modern Principles: Macroeconomics” by Tyler Cowen and Alex Tabarrok:

    You’ll note that the rate of change in the aggregate demand (AD) curve is equal to the sum of the inflation rate and the rate of change in real GDP (RGDP), and so is precisely equal to the rate of change in nominal GDP (NGDP). The rate of change in NGDP is determined by both fiscal and monetary policy in the short run but in the long run the rate of change in NGDP is determined solely by monetary policy.

    Note also the short run aggregate supply (SRAS/AS) curve and the Solow growth curve. The Solow growth curve is essentially the long run AS curve (LRAS). In the short run wages and prices are sticky causing the SRAS curve to be upwardly sloped. In the long run money is neutral and wages and prices are flexible so the Solow growth curve is vertical. Thus shifts in AD influence the rate of growth of RGDP in the short run, but not in the long run.

    Similarly, shifts in AS influence the inflation rate in the short run, but in the long run the inflation rate is determined solely by AD (i.e. monetary policy).

    The point is, the only coherent way to assess the short run impact of monetary policy (or fiscal policy for that matter) is its effect on NGDP, not inflation.

  34. @Jordan

    “Cause it helps banks to survive, only.
    If healthy banks (who are not healthy yet) have someone to lend to then it would be ok and monetary policy would work.”

    The Traditional Interest Rate Channel is only one of the nine channels of the Monetary Transmission Mechanism (MTM) as enumerated by Frederic Mishkin.

    The following paper by Mishkin gives an overview of the MTM:

    Click to access Ch26-supplement.pdf

    You might find the following table, found in the author’s best selling intermediate monetary economics textbook useful:

    To understand what’s been driving the U.S. recovery since 2009Q2 it might be useful to look at real GDP (RGDP):

    http://www.bea.gov/iTable/iTableHtml.cfm?reqid=9&step=3&isuri=1&910=X&911=0&903=6&904=2009&905=2013&906=Q

    Over the past 16 quarters RGDP has increased by $1291.8 billion in 2009 dollars at an annual rate. Net exports have subtracted $91.2 billion and government consumption and investment has subtracted $191.6 billion. Thus the other components of RGDP have grown by $1574.6 billion. Investment has contributed $594.1 billion (37.7%), consumption $567.8 billion (36.1%), durable goods $321.6 billion (20.4%) and residential investment $109.2 billion (6.9%). (It doesn’t add up to 100% because of the residual.)

    There are some immediate takeaways from this breakdown.

    1) Given that there are only two ways policy makers can impact aggregate demand, fiscal and monetary policy, and that government consumption and investment has been an enourmous drag on the recovery, it’s safe to say whatever recovery we have is due entirely to monetary policy.

    2) Since net exports have been a net drag it’s also safe to say that the Exchange Rate Channel has not contributed to the recovery. This is not surprising given the dollar’s relative strength compared to many of the U.S.’ trading partners, as well as relatively weak demand abroad.

    3) Non-residential investment has contributed substantially to the recovery. But since so many channels impact it, it’s difficult to say without further analysis what the relative contribution of each of the channels is.

    4) Consumption’s contribution to the recovery is also substantial, and this implies that the Wealth Effects Channel is probably the most important source of the recovery so far. This should not be too surprising in that household sector net worth has risen from about $48.7 trillion in 2009Q1 to $70.3 trillion in 2013Q1 according to the Federal Reserve Flow of Funds:

    http://www.federalreserve.gov/releases/z1/

    5) Durable goods have also contributed strongly to the recovery and this implies that the Traditional Interest Rate Effects Channel and the Household Liquidity Effects Channels have been important. (Note that the Household Liquidity Effects Channel is also asset price driven.)

    6) Residential Investment so far has contributed relatively little, which tends to speak against the Bank Lending Channel’s importance during this recovery, since mortgage lending accounts for three quarters of household sector debt. This shouldn’t be too surprising given that the household sector’s outstanding mortgage balance has shrunk by $1,083.1 billion since 2009Q2.

  35. @Jordan

    “FED is keeping banks NOMINALY solvent. Why are you guys wasting time with solved problem when REAL problems are still present?”

    The big four advanced currency areas that are currently at or near the zero lower bound in policy interest rates are the U.S., the eurozone, Japan and the U.K.

    One proxy for the amount of QE done is monetary base expansion. This isn’t perfect of course since it also measures other policy responses such as “credit easing”. The ECB has done credit easing but no QE for example. But let’s not make things too complicated for the moment.

    As of May the BOE’s monetary base was up by 348% since August 2008, the Federal Reserve’s up by 260%, the BOJ’s up by 75% and the ECB’s up by 48%:

    Now here’s the broadest monetary aggregate reported by each of the four central banks (the Fed’s MZM, the ECB’s M3, the BOJ’s L and the BOE’s M4) indexed to 100 in August 2008:

    As of May the Fed’s MZM and the BOJ’s L were up by 34% and 4% respectively. As of April the ECB’s M3 and the BOE’s M4 were up by 7% and 16% respectively. In terms of monetary base growth the BOJ recently surpassed the ECB in April, so other than that recent change in positions and the temporary surge in the BOJ’s monetary base in March to August 2011, the relative money supply growth rankings of the ECB and the BOJ match the relative monetary base growth rankings very well. And since changes in broad money supply seem to lag changes in monetary base by several months, and given the current trajectory of the BOJ’s L, it’s likely that the BOJ’s L will surpass the ECB’s M3 in terms of relative growth before too long. On the other hand a consistent pattern between the relative money supply growth rankings and the relative monetary base rankings of the Fed and the BOE is far less easy to detect. Nevertheless it is clear that the two currency areas that have most significantly expanded their monetary base since the Great Recession have also led in money supply growth.

    Since aggregate demand (AD) is the appropriate measure of the effectiveness of macroeconomic policies whose ultimate purpose is in fact to stimulate AD, perhaps we should look at the relative AD performance of the four large advanced currency areas since the Great Recession. But before we do that, we should take a look at the other main policy tool for stimulating AD, namely fiscal policy.

    In my opinion the most objective way of measuring fiscal policy stance is the change in the general government cyclically adjusted balance, particularly the cyclically adjusted primary balance (CAPB). The cyclically adjusted balance takes into account any changes in the general government budget balance due to the business cycle. Thus changes in the cyclically adjusted balance are mostly due to discretionary fiscal policy, and consequently may be taken as a proxy for the degree of fiscal stimulus. The CAPB goes a step further, factoring out changes in net interest on government debt and thus ensuring that practically all of the changes in fiscal balance are discretionary in nature. The following is a graph of the changes in CAPB by currency area over the calendar years 2009-13. All data comes from the April 2013 IMF Fiscal Monitor.

    The first thing you should note is that Japan has had the most expansionary fiscal policy every year without exception. And although all of the currency zones adopted a much less expansionary fiscal policy stance in 2010, it was the U.K. that took the lead in fiscal consolidation, having the most contractionary fiscal policy in both 2010 and 2011. The U.S. has had the most contractionary fiscal policy starting with calendar year 2012.

    Now, let’s take a look at relative AD performance. To be technical, AD is nominal GDP (NGDP) when inventory levels are static (i.e. nominal Final Sales of Domestic Product). Thus for all intents and purposes AD is virtually identical to NGDP. The following is a graph of the NGDP of the four big advanced currency areas with NGDP indexed to 100 in 2008Q2, that is, before large scale monetary base expansion started in September 2008.

    https://research.stlouisfed.org/fred2/graph/?graph_id=125131&category_id=0

    Note that the U.K. led in relative NGDP growth from 2010Q1 through 2011Q3 with the exception of 2010Q4 and 2011Q2. The U.K. also led in relative monetary base growth from June 2009 through January 2011 and relative money supply growth from July 2009 through August 2011. And as previously noted the U.K. had the most contractionary fiscal policy in 2010 and 2011.

    The U.S. has led in relative NGDP growth since 2011Q4. The U.S. also led in relative monetary base growth from February 2011 through January 2012 and has led in relative money supply growth since September 2011.And as previously noted the U.S. has had the most contractionary fiscal policy starting with calendar year 2012.

    Japan has ranked last in relative NGDP growth throughout. Japan has also ranked last in relative monetary base growth with the exception of March through August 2011 and since April 2013, and Japan has ranked last in relative money supply growth throughout with the sole exception of June 2010. And as previously noted Japan has had the most expansionary fiscal policy throughout.

  36. @John Quiggin

    “As regards the views of policymakers, as I’ve already said, I’m much more inclined to place weight on Bernie Fraser’s statements at the time than on the retrospective claims made later on. Googling Fraser’s speech, the remarks you cite are obviously a defence against the widespread perception that policy was not merely expansionary, but too expansionary.”

    But the fact that the RBA was concerned about inflation at all was apparently something new. Stephen Kirchner in 1996 (Page 11):

    “The RBA’s current preoccupation with inflation is a relatively new development. Up until the early 1990s, monetary policy had been focused on demand management, with a particular emphasis on reducing the size of the current account deficit (see e.g. RBA 1989: 6-7). This activist and highly discretionary monetary policy was the main contributor to the 1990-92 recession, as the authorities seriously misjudged the implications of high interest rates for the level of economic activity. However the recession also contributed to a substantial reduction in the rate of inflation from the early 1990s, a reduction that was characteristic of many of the world’s industrialised economies.

    The reduction in inflation was accompanied by a significant change in the policy approach of the RBA. The RBA had been traditionally hostile to a single monetary policy focus on inflation and inflation targeting, and still maintains reservations about such an approach (e.g. Fraser 1991: 6-8). This is in contrast to the much stronger focus on price stability and inflation targeting increasingly found in other countries such as New Zealand. However the 1990-92 recession was quickly rationalized as an opportunity to reduce inflation. For example, the RBA Deputy Governor Ian Macfarlane (1992: 77) described the recession as a “once in a decade opportunity to return to low inflation.””

    Click to access 1996-12-3-stephen-kirchner.pdf

  37. @Mark A. Sadowski
    Why do you want to restart world economic history at 16 quorters ago?
    Or what is the point of all those info you provided?
    that there is a recovery and all is fine, just wait another 20 years and everyobody who wants will get employed?

    Maybe you are fine with unemployment numbers but NGDP is what matters!!
    There is no recovery in employment and no recovery in prosperity. There is no recovery for people which is what matters.

    I can give you many ways to improve economic numbers without improving people’s lives.
    People’s lives are what matters, not your look at static numbers. You economists waste people’s inteligence resource.

  38. I appologize for the last sentence.

    REAL problem from my sentence you quoted was people’s lives. I was not talking about size of the numbers in accounting sheet of governments which you find relieving.

    Banks are fine now, why they do not transmit such expansion in base money to the real economy?

  39. @John Quiggin

    “A side point on which I need to clarify my own thoughts. In assessing the stance of both fiscal and monetary policy, I tend to think that both the level and the change need to be considered.”

    But there’s a fundamental difference.

    An increase in the cyclically adjusted budget balance (CABB) is contractionary. No change in the CABB does nothing. A decrease in the CABB is expansionary. All of this is true regardless of the size in the change in the CABB.

    On the other hand if a real policy interest rate is 7% above the real neutral rate it is contractionary. An increase in the real policy rate will make it more contractionary. No change in the real policy rate will keep it at the same contractionary level. A reduction in the real policy rate may be contractionary, neutral or expansionary depending on its size.

    “Cutting rates by 12 percentage points is a clear signal that the authorities want to raise the level of nominal GDP sufficiently to reduce unemployment and will do what they think is necessary to achieve that.”

    Not if they take three years to do it during a time of significant disinflation.

    Consider the rate of decline in the three previous nominal declines of 6 or more points in short term interest rates in comparison, and specifically consider how many months it took to decrease short term rates 6 points from peak.

    Short term rates dropped from 19.3% in April 1982 to 13.0% to November 1982, a period of seven months. They declined from 19.4% in December 1985 to 12.8% in April 1986, a period of four months. They declined from 16.6% in January 1987 to 10.5% in October 1987. The average number of months for these three declines to take place was about 6.7 months.

    Now compare that to the 1990 recession. Short term rates peaked at 17.9% on October 1989. It took 14 months for them to drop to 11.8% in December 1990. That’s a period of time over 50% greater than any of the previous three episodes and over twice as long as the average of the previous three episodes.

    What kind of a signal do you think that was sending?

    Here is a link to the data:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135223&category_id=0

  40. @Mark A. Sadowski
    Why the monetary policy does not work at the present, or it works if you give it let’s say 20 years without another finacial collapse?
    Why all those of 9 MTM do not work? (actually some of them do, contractionary ones, while others are simply shifting resources from one segment into another so no improvement in total).

    To start from wrong assumptions, here is work from James Tobin 50 years ago where he explains something important that is not considered.

    Where do Bank Reserves come from in normal times, not from QE as today?
    If bank reserves come from savings, how can those same reserves that are at the CB still be employed as investment or consumption? And also those reserves are replaced with Treasuries when too much of it to manage cash rate?
    If saving=investment how they can also be reserves at the FED and in Treasuries at the same time that are invested?

    Monetary policy increased bank reserves, right?
    Why are they still there?

  41. @John Quiggin

    “They declined from 16.6% in January 1987 to 10.5% in October 1987.”

    should read

    “They declined from 16.6% in January 1987 to 10.5% in October 1987, a period of nine months.”

  42. @Jordan

    “Why do you want to restart world economic history at 16 quorters ago?”

    The recovery started 16 quarters ago. I thought it might be instructive to see exactly how the various channels of the monetary transmission mechanism (MTM) are bringing this about.

    “Or what is the point of all those info you provided?
    that there is a recovery and all is fine, just wait another 20 years and everyobody who wants will get employed?”

    The current pace of recovery is clearly not satisfactory. But there is a recovery and since fiscal policy stance is very contractionary this suggests that monetary policy must be offsetting it to some degree. I am suggesting that we need even better monetary policy to increase the pace of recovery.

    “Maybe you are fine with unemployment numbers but NGDP is what matters!!”

    No, on the contrary, I am not at all happy about the unemployment numbers. But both monetary and fiscal policy work through NGDP. NGDP in turn affects real GDP (RGDP) which is closely correlated to the level of employment. My point is you can’t measure the effectiveness of policies meant to stimulate aggregate demand (NGDP) by the inflation rate.

    “There is no recovery in employment and no recovery in prosperity. There is no recovery for people which is what matters.”

    There is a recovery; it’s just that its pace is unsatisfactory. We need to increase the rate of recovery.

    “Banks are fine now, why they do not transmit such expansion in base money to the real economy?”

    For various reasons I do not think bank lending will play much of a role this recovery. But fortunately bank lending is only a small part of how monetary policy works.

  43. But fortunately bank lending is only a small part of how monetary policy works.

    It is the only way that monetary policy works, it is through bank lending.
    Bank lending affects all 9 MTM channels, even exchange rate because lending aconsumption which comes from foreign trade too and also affects foreign investments.
    Bank lending affects stock prices through consumption and through margin debt. Margin debt which is used to buy options and stocks has very nice corelation with stock prices and i would say that it also imply causation.

    My previous post that is in moderation has nice questions for you that questions your assumptions about banks and credit creation or money supply or why monetary policy does not work anymore.
    If bank reserves are at the CB, how savings=investment and reserves at the same time and some savings are in Treasuries which are spent?

  44. Perhaps Mark would like to ponder why simple rate cuts are usually good enough to spur growth but now all of a sudden they aren’t for some economies. Wouldn’t have anything to do with the enormous amount of private debt outstanding would it?

  45. John, Thanks for the post. A couple comments:

    1. I have discussed a very specific policy rule–peg the price of NGDP futures contracts along a 5% growth rate path. The futures contracts serve the role of the fed funds rate in NK models. The base and interest rates become endogenous.

    2. Yes, I did say most economists equate the stance of monetary policy will interest rates. But I also said that the number one monetary textbook in America says that is wrong, as do many elite monetary economics (Friedman, Bernanke, Mishkin, etc) I’m claiming that the average economist is lagging behind elite opinion. I claim there is no coherent argument for equating the stance of monetary policy with interest rates, and shifting from nominal to real rates doesn’t make it coherent.

  46. @Jordan

    “It is the only way that monetary policy works, it is through bank lending.
    Bank lending affects all 9 MTM channels, even exchange rate because lending aconsumption which comes from foreign trade too and also affects foreign investments.”

    You seem to be claiming that bank lending is necessary in order to decrease the value of a currency. But I compared the year on year change in private credit market instrument leverage as a percent of GDP with the Real Trade Weighted U.S. Dollar Index from 1973Q1 and found not a negative correlation, but positive one, stignificant at the 1% level. I’m not sure what this means but it’s the complete opposite of what you are predicting:

    http://research.stlouisfed.org/fred2/graph/?graph_id=135265&category_id=0

    “Bank lending affects stock prices through consumption and through margin debt. Margin debt which is used to buy options and stocks has very nice corelation with stock prices and i would say that it also imply causation.”

    There are tests for causation. The margin debt data can be found here:

    http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=tables&key=50&category=8

    I ran a Granger causality test between margin debt and the S&P 500 Index from January 1959 on forward using a method developed by Toda and Yamamato and found that the stock index Granger causes margin debt but margin debt does not Granger cause the stock index. I also found an article published in a third rate journal that applied Granger causality tests to margin debt and stock market returns and which found identical results:

    http://www.thefreelibrary.com/Margin+debt+balance+vs.+stock+market+movements+and+expected+GDP…-a0263157440

    “My previous post that is in moderation has nice questions for you that questions your assumptions about banks and credit creation or money supply or why monetary policy does not work anymore.”

    I guess I’ll have to wait until it is released from moderation to address these claims.

    “If bank reserves are at the CB, how savings=investment and reserves at the same time and some savings are in Treasuries which are spent?”

    I can’t make any sense of that statement. If you can’t take the time to express yourself clearly why should I take the time to respond.

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